In competitive markets, prices fall

In ‘Free: How Today’s Smartest Businesses Profit by Giving Something for Nothing’, the follow up to ‘The Long Tail’, Chris Anderson discusses how in markets that are serviced by many, highly competitive companies, prices tend to fall.

“In 1838, Antoine Cournot, a French mathematician living in Paris, published Recherches, now considered an economic masterpiece (although not many thought so at the time). In the book he attempted to model how companies compete, and concluded, after a lot of math, that it all had to do with the amount they produced. If one factory was making bowls and another company wanted to open a factory that also made bowls, it would be careful not to make too many, for fear of flooding the market with bowls and driving the price down. The two firms would somehow simultaneously and independently regulate their production to keep prices as high as possible.

The book was, as is often the case for even the most inspired works, promptly ignored. The members of the French Liberal School, who dominated the economics profession in France at the time, were uninterested, leaving Cournot dispirited and bitter. (He nevertheless went on to have a distinguished career, won lots of awards, and died in 1877.) But after his death, a group of younger economists returned to Recherches and concluded that Cournot had been unjustly neglected by his contemporaries. They called for his competition models to be reexamined.

So, in 1883, another French mathematician, Joseph Bertrand, decided to give Recherches a proper review. He hated it. As the Wikipedia entry on Cournot puts it, ―Bertrand argued that Cournot had reached the wrong conclusion on practically everything.‖ Indeed, Bertrand thought that Cournot‘s use of production volume as the key unit of competition was so arbitrary that he, half-jokingly, reworked Cournot‘s model with prices, not output, as the key variable. Oddly, in doing so he found a model that was just as neat, if not neater.

Bertrand concluded that rather than limit output to raise prices and increase profits, companies would more likely lower prices to gain market share. Indeed, they would attempt to undercut each other until the price was just above the cost of production, which is called ―marginal cost pricing.‖ And if the lower prices encouraged greater demand, so much the better.

Bertrand Competition can be shorthanded like this:

In a competitive market, price falls to the marginal cost.

Of course, in those days there weren‘t many truly competitive markets, at least not the way these mathematicians‘ models defined them: with homogeneous products (no product differentiation) and no collusion. So other economists dismissed the two as theoreticians trying to unnecessarily fit complex human behavior into stiff equations, and for the next few decades the spat was forgotten as yet another academic dispute.

But as economics moved into the twentieth century and markets became competitive and more measureable, researchers returned to these two feuding Frenchmen. Generations of econo Ctio.†mics graduate students labored to figure out which industries lent themselves more to Cournot Competition and which to Bertrand Competition. I‘ll spare you the details, but the short form is this: In abundant markets, where it‘s easy to make more stuff, Bertrand tends to win; price often does fall to the marginal cost.”

The opposite has also been found to be true. In an article in The Washington Post, Lina Khan and Sandeep Vaheesan discuss how in markets that are serviced by few, dominant players prices tend to rise.

Hey. I’m Alex Murrell. I'm a Planner at Epoch Design in Bristol where I help deliver highly creative, innovative and effective pack, instore and online communications for some of the world’s biggest FMCG brands. Want to know more? You can find me on Twitter or LinkedIn.

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